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Essential Technical Analysis
Tools and Techniques to Spot Market Trends
The discipline of technical analysishearing the message ofthe market through price movementsis a valuable tool formaking profitable trading and investing decisions. Once youunderstand the concepts and techniques of technical analysis, yourview of the market and how you trade or invest within it will beforever changed.
Essential Technical Analysis: Tools and Techniques to SpotMarket Trends is a simple, accessible, and straightforwardintroduction to technical analysis. Whether you’re ashort-term trader or die-hard investor, respected technical analystand CNBC affiliate Leigh Stevens will show you how to use thispopular stock, bond, and futures trading technique to make money inboth up and down markets.
Essential Technical Analysis demystifies technical analysis forthe beginner. You’ll become familiar with basics such astrends, chart patterns, and price and volume indicators, andyou’ll learn how to put them all together so you can begin toconsistently lock in profits. Numerous examples, based primarily onstocks, and clear explanations provide a solid framework for usingtechnical analysis to better understand the dynamics of marketmovements and trends.
In Essential Technical Analysis, Leigh Stevens’s real-worldexperiences using technical analysis shine through and fill thesepages with useful tips, tools, and techniques that have beenconsistently accurate and profitable over the years.
In-depth coverage includes:
The goal of Essential Technical Analysis is to provide you withthe most useful and practical techniques that could increase theprofitability of your investing and trading activities. With thiscomprehensive guide at your side, you’ll learn how to usetechnical analysis and begin to make informed and accuratedecisions that will boost your trades and investments in anymarket.
METHOD AND GOALS OF THIS BOOK
The goal of this book is, like my CNBC.com technical analysis columns that came before it, to present technical analysis tools and insights that can help you make more informed, and more profitable decisions relating to trading and investing. I utilize the U.S. stock market for all examples. I also discuss some indicators and aspects that are particular to the stock market.
A major related purpose of the information and stories I present is that a process is begun whereby you start to look at markets in a different way, to see beyond the usual way that market information is presented to you or understood by you. I emphasize again my hope that you will be able to profit from this information. A major consideration is to discuss and demonstrate what I consider to be the more useful tools and methods from technical analysis-for example, demonstrating how to locate stocks that offer the best hope of gain at the right time, at lowest risk, and with an effective exit strategy. There are less used technical tools and analysis techniques that could be described but that might be marginal for most people, in terms of improving trading and investment decisions.
A second orientation I have is to discuss some of thepitfalls to improved trading and investing decisions, such as your attitude toward the market-is it gambling or is it profitable investing or trading that you can master? How much time will you invest in it and how much perseverance will you maintain? I find that a person's emotional temperament, work habits, discipline, and ability to see ahead (foresight) are as, or sometimes more, important as mastery of some of the more complex areas of technical analysis. Time spent and perseverance in understanding the most basic use of charts and technical indicators are more important to most market participants than exhaustive study of every aspect of this field. And there is a great tendency among people to think that complex ideas and techniques must be the way to approach the markets, which after all, are complex mechanisms. This is wrong, as simple is better in my experience, and I am not the only one saying this-many top advisors and money managers base their decisions on a relatively simple set of criteria.
USE OF EXAMPLES
I use stock and stock averages exclusively for all examples in this book relating to demonstrating technical patterns and indicators. While I also have a background in the futures, fixed income, and foreign exchange markets, I will not provide chart examples from these markets, or discuss aspects of these markets that are unique to them-for example, describing open interest and how to use it in futures or the ways of constructing a continuous contract price series from the various futures contract-months. I do discuss some custom indicators and methods of analysis that are unique to the stock market, as I believe I have something unique to say about these things. However, again I want to emphasize that all general technical analysis principles, which comprise most of this book, are applicable to all markets.
The popularity of technical analysis owes much to its initial widespread use in the commodities markets, especially in the 1970s, when these markets were very active, drawing in many individual futures traders. Technical analysis is very popular in the biggest single market in the world-the interbank currency market, usually just called the foreign exchange or FX market. Having worked in this area in Europe, I can say that I understand a major reason for this-a chart or a technical indicator is the same in any language. This said, I do not draw, for example, on FX charts of dollar-yen or of the eurodollar for my illustrations.
I do, however, point you to other books with a more detailed and specialized orientation toward other markets or specialized fields within technical analysis that you may want to study further if you're interested-for example, on candlestick charting or wave analysis. Some of what I consider to be the best reference works on technical analysis are provided at the end of the book in a recommended reading list. Some of these books draw on more examples from the futures markets, for example.
NEED FOR TECHNICAL ANALYSIS
There are plenty, in fact a majority, of successful money managers who say they don't use technical analysis at all. There are also rich investors and speculators who rely mostly on technical analysis. It's not the method; it's the person-just as Jack Schwager found in his wonderful Market Wizard series of books.
You may not have the emotional temperament or time for short-term speculation in the market, which is my situation, but you can still vastly improve your batting average when it comes to longer-term investing, such as in stocks. You can focus on looking at long-term charts and indicators only-however, don't get married to a stock, either. Even very long-term investors decide it's time to exit a stock or stock sector and look for other situations. This group of individuals can benefit from stock market timing to find a more advantageous (cheaper) entry into a stock or mutual fund or to exit when a primary trend reverses.
WHAT IS TECHNICAL ANALYSIS?
The word technical comes from the Greek technikos, relating to art or skillful. Webster's goes on to define technical as having special and practical knowledge, something I want to reinforce also. Technical analysis is the study of any market that uses price and volume information only in order to forecast future price movement and trends. (Consideration of a third factor, that of open interest, is part of the technical approach in the futures markets only.)
Technical analysts and technically oriented investors or traders rely on historical and current price and volume information only. Some other, related, statistical information is often considered part of technical analysis. What I refer to here are sentiment indicators, such things as surveys of market opinion to determine whether the respondent is bullish, bearish, or neutral on the market. These figures are compiled as percentages of those surveyed having each type of opinion, for example, the weekly Investor's Intelligence opinion survey of market professionals or the American Association of Individual Investors (AAII) poll of its members. Studies of short interest in stocks or extreme readings in the Arms Index (TRIN) are also in this category.
A THIRD ELEMENT BESIDE PRICE AND VOLUME
The rationale for studying market opinion is the theory of contrary opinion. The idea of contrary opinion in market analysis is that there is value at certain times or in general of going against the predominant view of stock valuations or expected market direction. Warren Buffett, considered a master of value investing, looks for value in stocks that may not be perceived by the majority of fund managers. Market makers on the New York Stock Exchange (NYSE) buy when others are selling and vice versa and they make money doing it. The most knowledgeable investors and traders comprise a top tier of market participants, in terms of market knowledge. This group often profits handsomely by being contrary to the investing crowd, buying when others are fearful of a further decline and selling when the majority thinks a stock or the market will go up indefinitely.
Market psychology, sentiment, or contrary opinion, could be called a third element in technical analysis but is not part of the formal definition of technical analysis. My favorite sentiment indicator is actually a ratio of total daily equity call option volume relative to the volume of equity put options. I tend not to rely on survey type information but do place significant emphasis on whether options market participants are speculating or hedging heavily on one side of the market or the other-whether, as a group, they are betting on a rise or fall in the market. Even here I rely on volume information, which is part of technical analysis input.
The terms applied to the use of technical analysis include technical analysis, the technicals or technical factors-not to be confused with tech or technology stocks or technical factors impacting a market, such as a computer failure or blizzard in causing an exchange to close early. Technical analysis means a set of principles and analytical tools that are used to make predictions about the market that predominantly involve the use and study of price and volume information only.
Fundamental analysis, rather than concentrating solely on the study of market action itself, relies on examination of the laws of supply and demand relating to a market or to individual stocks. The aim is the same, to determine where stock prices may be heading. Much of fundamental analysis revolves around one basic area-earnings. What is a company likely to earn in its business during the current time frame and going forward? Or what is the earnings potential of an entire group of stocks, such as the S&P 500? Relative to earnings, what multiple is the market likely to assign to the value of the stock or market index? Will, or should, the price of the stock trade at a value that represents 10, 15, or 50 times past and future (projected) earnings in dollar terms? Price/earnings ratios or P/E considerations form the core of fundamental analysis of stocks.
Relative to P/Es, the broad area of investor sentiment provides an area where fundamental and technical analysis overlap. Whether a stock should or will trade at a price/earnings ratio of 10, 15, or 50 is more than a matter of economic and company growth expectations, it is also a matter of investors' bullish or bearish sentiment. Market participants may decide that they will no longer reward growth stocks with a P/E ratio that is far above the average simply based on having seen a recent collapse of such ratios. Or their views of a company's or industry's growth prospects may be good, but a more cautious attitude takes hold, forcing a downward adjustment to stock prices, when even the fast growing companies with rapidly expanding earnings no longer command hefty premiums to the average stock.
TECHNICAL ANALYSIS RATIONALE
Why would someone rely on just studying charts that plot past and current price and volume information, as well as perhaps technical indicators or formulas that use the same information?
The reasons are found in observations of the stock market, as first noted by Charles Dow in this country and can be described in three ways.
1. Efficient Market. Over time, market prices reflect everything that can be known about a stock and its future prospects. The market as a mechanism is very efficient at discounting whatever can affect prices. Even unforeseen events, such as new competition, legal or financial problems, a company takeover, the death of a founder, and so on are quickly priced into the stock. Even unknown (not yet publicized) fundamental factors, such as a sharp earnings drop, are seldom unknown or unanticipated by everyone; those who know often act on the information, and selling volume starts to pick up on rallies. Here I am not talking necessarily about facts known only by company insiders. There are traders, investors, and analysts outside a company or an industry who see changes coming, through astute observation and sharp analysis.
2. Trends. The information about a company's stock and its future earnings prospects that are reflected in the stock price will also be reflected in a price trend or tendency to go up or down. Trends are not only up or down, but sideways as well or what is sometimes called a trendless pattern-I consider a sideways movement to be the third trend possibility, for example, a stock moves between 40 and 50 multiple times. A trend is the action of a body in motion staying in motion until an equal countervailing force occurs.
3. Reoccurrence. Price trends occur and reoccur in patterns that are largely predictable. The idea of trends reoccurring is that history repeats itself. If there was abundant stock for sale (supply) previously for sale at 50 and that selling caused a retreat in prices, it may well be the case again when the stock approaches this level again. If it doesn't, that tells you something also, as demand was this time strong enough to overcome selling.
The basic technical analysis rationale can be remembered by the ETR acronym (as in Estimated Time of Arrival). Well, you can estimate arrivals with technical analysis!
TECHNICAL VERSUS FUNDAMENTAL ANALYSIS
If you are reading this book, I assume you have an open mind as to the possible validity of technical analysis. I see no contradiction between these forms of analysis. I often use technical analysis as an adjunct to fundamental analysis-I may like a market sector or individual stock for fundamental reasons, for example, computer use is on a path of explosive growth. I might then use technical analysis for or because of
* Market timing-when to get in, for example, a pullback to a trendline
* Risk control-judging where to place protective stop (liquidating) orders, for example, on a break of a major trendline
* An end to a trend-applying criteria for when a trend may have reversed, for example, a decisive downside penetration of a stock's 200-day moving average
There are other reasons to use charts, of course, even if you don't use technical analysis techniques, such as for seeing price and price volatility history.
Not only do I not see the two means of analysis to be complementary, but I also consider technical analysis to be a shortcut or an efficient way to do stock market fundamental analysis! I may not be able to or want to study everything about the ongoing progress of a company whose stock I own. However, there are always an interested body of people who trade the stock and make informed investment decisions because they know the company or business quite well.
Excerpted from Essential Technical Analysis by Leigh Stevens Excerpted by permission.
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CHAPTER 1: Introduction and Rationale to the TechnicalApproach.
CHAPTER 2: Our Trading or Investing Game Plan.
CHAPTER 3: Charles Dow and the Underlying Principles of MarketBehavior.
CHAPTER 4: Price and Volume Basics: Chart Types and PriceScales.
CHAPTER 5: Concepts of Trend and Retracements and ConstructingTrendlines.
CHAPTER 6: Recognition and Analysis of Chart Patterns.
CHAPTER 7: Technical Indicators.
CHAPTER 8: Confirmation and Divergence.
CHAPTER 9: Specialized Forms of Analysis and Trading.
CHAPTER 10: Putting It All Together.
RECOMMENDED READING LIST AND OTHER RESOURCES.